In what can only be described as a new low in defining deviancy down on Wall Street, Thomson Reuters’ International Financing Review (IFR) reported this past weekend that some of the biggest names on Wall Street have returned to creating and/or trading synthetic collateralized debt obligations (Synthetic CDOs).

The products were a major factor in bringing the U.S. financial system to the brink of failure in 2008. Synthetic CDOs also resulted in hundreds of millions of dollars in fines and reputational damage to these same Wall Street behemoths as investigators found that the firms were allowing hedge funds to pick “crap” subprime mortgage bonds to stuff in the CDOs in order to make windfall profits for the hedge fund, which shorted (bet against) the CDOs. The Wall Street firms had full knowledge of what the hedge funds were doing but, nonetheless, peddled the investments as sound to unsuspecting investors. In some instances, the same Wall Street firm that was selling the product as a good investment to public pension funds, school districts, churches and insurance companies, was also making short bets itself against the CDO. In at least one case involving Goldman Sachs, it placed a 10 to 1 short bet on failure of its own product.

Writing for IFR, Christopher Whittall reports that “Trading volumes in synthetic collateralised debt obligations linked to credit indexes are up 40% this year, according to JP Morgan, after topping US$200bn in 2018 on the back of three years of double-digit growth. Meanwhile, analysts predict more than US$100bn in sales of bespoke synthetic CDOs in 2019 following an estimated US$80bn of issuance last year.”

Who are the major players in this market? According to Whittall, Citigroup is a major player while Deutsche Bank has “an eye on expanding in this market.” Our own sources tell us that Morgan Stanley has also structured deals in the past two years.

The bombshell here is not about the trading of synthetic CDOs. Firms can do that all day long without exposing their balance sheets and the U.S. economy to collapse. The bombshell is that the bespoke (custom-made) synthetic CDO market has returned to Wall Street and if analysts are predicting $100 billion this year after an estimated $80 billion last year, that means the real secret number is dramatically higher. Those figures also reveal nothing about how much shorting is going on. That could be 10 to 1 or even 20 to 1.

Instead of subprime mortgages being targeted this time around, what’s being stuffed into these bespoke products is corporate debt – which has exploded over the past decade, in no small part because publicly-traded corporations and Wall Street banks are being allowed to prop up their share prices through stock buybacks financed with debt.

The second bombshell in Whittall’s article is that one of the most suspect banks on the planet, Citigroup, is re-engaging in this market. Citigroup’s off-balance sheet CDOs and the secret puts it had written on them played a major role in blowing up the global bank in 2008 after Sandy Weill had walked away as a billionaire in 2006 and Robert Rubin, the former Treasury Secretary, had raked in over $120 million in compensation.

Citigroup received the largest taxpayer bailout in U.S. history from 2007 to 2010 to prevent it from bringing down the rest of the street. The bank was interconnected, through derivatives and loans, to almost every major player on Wall Street as well as global foreign banks. If it went bust, it was going to take down a lot of other key players with it.

What the public was allowed to know at the time of Citigroup’s bailout was that it received $45 billion in equity infusions from TARP – the Troubled Asset Relief Program approved by Congress; a guarantee of over $300 billion from the Federal government for its dodgy assets; a guarantee of $5.75 billion on its senior unsecured debt and $26 billion on its commercial paper and interbank deposits from the Federal Deposit Insurance Corporation. What the public was not allowed to hear about at the time was $2.5 trillion in revolving, low-interest-rate loans pumped into the insolvent behemoth by the Federal Reserve, in violation of the Fed’s mandate to only lend to solvent institutions. These details did not fully emerge until the Government Accountability Office released its audit of the Fed’s secret lending programs in July of 2011.

That Citigroup has now returned to these products is nothing short of breathtaking in its brazen contempt for the sensibilities of the American people. It is also an indictment against every Federal regulator of Wall Street. As recently as May of 2015, Citigroup became a felon by admitting to charges brought by the U.S. Department of Justice over its role in rigging foreign exchange trading. Other banks were charged as well. (See A Private Citizen Would Be in Prison If He Had Citigroup’s Rap Sheet.)

To help movie audiences understand CDOs, The Big Short movie of 2015 put the blond, sexy Australian actress Margot Robbie in a bubble bath with a glass of champagne to explain the subprime “sh*t” that was stuffed into CDOs. To unravel the intentionally convoluted synthetic CDO, the movie offered up pop star Selena Gomez in a low-cut dress at a blackjack table along with the behavioral economics expert, Dr. Richard Thayer.

The problem with the Gomez-Thayer scene is that it creates what looks like a trading pit filled with average Joes around the blackjack table, and shows these average folks being able to make their own bets on the synthetic CDO. This is a critical misdirection in what actually happened. The public did not know anything about this complex product. Even if the public had wanted to make a wager, they couldn’t have because the product was sold under Rule 144A, meaning it didn’t have to be registered with the SEC under the Securities Act of 1933 because it was, ostensibly, only going to be sold to sophisticated institutional buyers. (This is a standard argument when Wall Street is hauled into court for fraud: these were big boys who should have known what they were doing.)

Details of the synthetic CDOs only began to make news as Wall Street crashed and investigators looked for answers.

The best description of how a synthetic CDO works is found in the report by the U.S. Senate’s Permanent Subcommittee on Investigations. Titled Anatomy of a Financial Collapse and released on April 13, 2011, the report offers this:

“Synthetic CDOs did not depend upon actual [residential mortgage-backed securities] RMBS securities or other assets to bring in cash to pay investors. Instead, the CDO simply developed a list of existing RMBS or CDO securities or other assets that would be used as its ‘reference obligations.’ The parties to the CDO were not required to possess an ownership interest in any of those reference obligations; the CDO simply tracked their performance over time. The performance of the underlying reference obligations, in the aggregate, determined the performance of the synthetic CDO.

“The synthetic CDO made or lost money for its investors by establishing a contractual agreement that they would make payments to each other, based upon the aggregate performance of the underlying referenced assets, using CDS contracts. The ‘short’ party essentially agreed to make periodic payments, similar to insurance premiums, to the other party in exchange for an agreement that the ‘long’ party would pay the full face value of the synthetic CDO if the underlying assets lost value or experienced a defined credit event such as a ratings downgrade. In essence, then, the synthetic CDO set up a wager in which the short party bet that its underlying assets would perform poorly, while the long party bet that they would perform well…

“Synthetic CDOs magnified the risk in the mortgage market because arrangers had no limit on the number of synthetic CDOs they could create. In addition, multiple synthetic CDOs could reference the same RMBS and CDO securities in various combinations, and sell financial instruments dependent upon the same sets of high risk, poor quality loans over and over again to various investors. Since every synthetic CDO had to have a ‘short’ party betting on the failure of the referenced assets, at least some poor quality RMBS and CDO securities could be included in each transaction to attract those investors. When some of the high risk, poor quality loans later incurred delinquencies or defaults, they caused losses, not in a single RMBS, but in multiple cash, synthetic, and hybrid CDOs whose securities had been sold to a wide circle of investors.”

One of the dirtiest and widely publicized synthetic CDOs was Goldman Sachs’ Abacus 2007-AC1, where Goldman had allowed John Paulson’s hedge fund, Paulson & Co., to select subprime instruments likely to fail. Goldman knew that Paulson was shorting the deal and thus he had every incentive to pick instruments likely to fail. Nevertheless, Goldman pitched the deal as a good investment to other unsuspecting investors. The SEC estimated that investors lost more than $1 billion in the deal while Paulson made $1 billion. Goldman paid $550 million to settle civil charges; Paulson didn’t even get fined; and a lowly Goldman salesman named Fabrice Tourre took the fall for the whole firm. Tourre was found guilty in a civil trial and fined $825,000.

While only a handful of Wall Street firms received big fines for doing similar deals, there is significant evidence that prosecutors have only scratched the surface as to the potential criminal network that was operating in this space and what was actually going on.

When Jonathan Egol, head of CDOs, Correlation and Derivatives at Goldman Sachs during and after the financial crisis, was interviewed by the Financial Crisis Inquiry Commission (FCIC), he was asked who else had bespoke CDOs similar to Goldman’s Abacus. Without hesitation, he rattled off a laundry list that effectively covered the whole street. Egol said Morgan Stanley had products called ABspoke, CMBspoke, Baldwin and Ballista; Credit Suisse had a product called Magnolia; Merrill Lynch had Steers and Calculus; BNP Paribas had Mermaid; Calyon had ABSolute; Societe Generale had Sonoma Valley; UBS had North Street; and Bear Stearns had Millbrook.

To this day, prosecutors have failed to put the majority of these products under a forensic microscope.

The Senate investigation reported that “Goldman Sachs alone packaged and sold $73 billion in synthetic CDOs from July 1, 2004 to May 31, 2007,” also noting that “synthetic CDOs created by Goldman referenced more than 3,400 mortgage securities and 610 of them were referenced at least twice. This is apart from how many times these securities may have been referenced in synthetic CDOs created by other firms.”

Were these Wall Street firms conspiring with each other as they have in so many other markets like Nasdaq price fixing, and Libor and foreign exchange? Prosecutors would have to be willfully blind not to see the potential for collusion.

Egol’s ability to rattle off all of these names without missing a beat stands in stark contrast to his inability to remember so many other details he was queried on by investigators for the Financial Crisis Inquiry Commission. (See Part 2 of the audio interview at approximately 21:30 on the tape. And don’t even get us started on why there is not a written transcript of this interview with Egol. Hint: Wall Street’s lawyers pounded the FCIC not to release to the public the interviews with their employees.)

The Big Short movie of 2015 is based on the book The Big Short: Inside the Doomsday Machine by bestselling author Michael Lewis, a former bond salesman at Salomon Brothers in the 1980s who has written extensively about Wall Street in the intervening years.

The week his book was due for release in March 2010, Steve Kroft interviewed Lewis on the CBS program, 60 Minutes. Throughout the interview, Lewis refused to characterize the conduct that led to the financial crash as criminal behavior. In response to a question, Lewis tells Kroft:

“I’m afraid that our culture will come to the conclusion, ’cause it’s always the easy conclusion, that everybody was just a bunch of criminals. I think the story is much more interesting than that. I think it’s a story of mass delusion.”

There is also a line in the movie that seems to be attempting to move the narrative away from criminal behavior. The character based on Greg Lippmann, a CDO trader at Deutsche Bank that is played in the movie by Ryan Gosling, pushes the narrative that there was no criminal actions, just stupidity. When the Steve Carell character (based on Steve Eisman of the hedge fund FrontPoint) calls the conduct “fraud,” Gosling says “Tell me the difference between stupid and illegal and I’ll have my wife’s brother arrested.”

The difference is actually very simple: if there is evidence of willful intent to defraud it’s not just the actions of a stupid person. And there is a mountain of evidence that there was willful intent, including lots of emails and the hundreds of millions of dollars of settlements paid to the SEC by the Wall Street firms over their synthetic CDO deals.

The reality is that it really was as simple as a bunch of criminals on Wall Street creating investment products designed to fail out of a motive to obtain obscene bonus compensation.

There is a second fake narrative that both the book and the movie have perpetuated in the mind of the public and which has, potentially, allowed these derivatives of mass destruction to return to the marketplace without making front page news.

That’s because Lewis has portrayed his key characters as the only folks to see the danger lurking in these instruments and the only ones smart enough to short the market. This gives the impression that this was not a conspiracy to defraud by the executives on Wall Street but just “mass delusion” that the U.S. housing market could never see a serious collapse.

Lewis tells Kroft in the 60 Minutes interview: “There are a handful of characters who actually had seen it coming and made a fortune off of it. And there were so few of them, and there were so many people who had been on the other side that I thought that I kind of wondered who they were and why they got themselves into that position.”

Asked how many people he thinks were in the world who understood what was going on, Lewis told Kroft, “Between 10 and 20 investors at most and this is from the universe of tens of thousands of people who could have conceivably made that bet.”

Unfortunately for the Lewis book and movie, there is now significant documentation that contradicts that statement, including all of those deals referenced by Jonathan Egol in his testimony before the FCIC, as well as the whistleblowers inside big firms like Citigroup and JPMorgan Chase who warned their bosses that the subprime mortgages were being accepted despite failing to meet the required standards for underwriting.

The Goldman Sachs’ Abacus deal in which John Paulson’s hedge fund made $1 billion by secretly shorting it was constructed in 2007. But there was an earlier Goldman deal called Abacus 2004-1. Goldman itself shorted that deal by 10 to 1. According to the FCIC, Goldman made about $930 million on the deal while the long investors lost almost all of their money.

Goldman Sachs had lawyers and risk officers and traders and department heads involved in its 2004 deal. That deal alone would have involved more than 10 to 20 people.

In the Lewis book, he says that Dr. Michael Burry began his shorting operation “in the beginning of 2005…No one on Wall Street, as far as he could tell, saw what he was seeing.” The book also claims that in 2005 there “was no such thing as a credit default swap on a subprime mortgage bond, not that he could see. He’d need to prod the big Wall Street firms to create them.” But here’s a graphic of the components of the Goldman Abacus 2004-1 deal and it clearly indicates that credit default swaps (CDS) were used in the deal.

And UBS had an even earlier deal in March 2002 using Credit Default Swaps – a synthetic hybrid CDO called North Street 4. UBS was sued by HSH Nordbank in 2008. The suit alleged that “UBS evidently regarded North Street 4 not as an investment platform but as an opportunity to defraud HSH. UBS knowingly and deliberately created a compromised structure based upon less desirable collateral…”

The HSH lawsuit goes on to explain:

“North Street 4 is a hybrid CDO, which takes a position in the underlying securities both through physical assets and derivative contracts. North Street 4 takes a position in the Reference Pool through a credit default swap between the CDO and UBS. A credit default swap is a means of transferring the risk of default on an underlying obligation — called a ‘reference credit’ — from one party to another. One party, the protection seller, agrees to assume the risk of loss on the reference credit in exchange for a stream of premium payments from the other party, the protection buyer for the period of the swap. If the reference credit defaults on its principal or interest obligations, then the protection seller must pay the amount of the shortfall. The protection seller, by assuming the risk of loss, takes a long position on the reference credit. Whether the assumption of risk by the protection seller in exchange for the premium is a good investment will depend upon the credit quality of the referenced securities, and specifically the risk and severity of any defaults, and the amount of the premium paid.”

There is a growing question in our mind as to whether The Big Short movie was a Hollywood propaganda film to take the heat off of the Justice Department over its failure to pursue criminal prosecutions. After all, as the movie narrative goes, only this handful of guys saw the collapse coming; after all, it was just stupid behavior not fraudulent behavior.

We’re not saying Michael Lewis was willfully part of the propaganda effort. His book came out in 2010 prior to the release of the findings from the Financial Crisis Inquiry Commission and the Senate’s Permanent Subcommittee on Investigations, both of which were released in 2011. And Lewis didn’t do the screenplay for the film. That was the work of Charles Randolph and Adam McKay — who notably won an Oscar in 2016 for Best Adapted Screenplay for The Big Short.

But it’s hard to believe that someone as savvy about Wall Street as Michael Lewis hasn’t changed his view about what really happened. It’s time for Lewis to share his thoughts on this issue with the American people – before the next Wall Street Doomsday Machine steamrolls across the economy.